The Critical Model Parameter: LGD

Abstract

Chapter 5 discusses the definition, relevance, and application of loss given default (LGD) to credit risk management, as well as possible estimation approaches. LGD is one of the main parameters, along with probability of default (PD) and exposure at default (EAD), of estimations for both the Basel II regulation and economic capital reporting purposes. LGD estimates are also crucial for the determination of impairment allowances according to the International Accounting Standards (IAS 39) framework. However, LGD’s importance should not be restricted to compliance requirements only, but should also be extended to business’ best practice in the measurement and optimization of collection and recovery processes. In fact, starting with credit origination, the correct estimation of a financial institution’s capability in recovery actions supports proper acceptance policies in terms of risk appetite and prices based on the risk profile. In such a context, severity models applied to open-default cases can suggest appropriate collection and recovery strategies that can lead to corrective actions on current criteria and the fine tuning of costs and resources.